Sunday, December 19, 2010

When speaking of national budget deficits, one of the magic numbers that has somehow emerged as a benchmark is 3 percent of gross domestic product (GDP). The International Monetary Fund often recommends this benchmark; and the European Union requires current and prospective members to keep their deficits below 3 percent.

Although 3 percent is way too high, let us not quibble. For the last couple of years the national budget deficit in the U.S. has been running around 10 percent. If we keep overspending at this rate, our national debt will increase by the size of our GDP every seven or eight years. Given that the total public debt outstanding is now more than 90 percent of GDP, the debt itself will double sooner.

We might console ourselves with the fact that the government owes one third of its debt to itself. Government agencies (such as the Social Security Trust Fund) hold U.S. Treasury securities, which are, rather inconveniently, IOUs on future taxpayers. This means that, when accounting for the interest cost on the debt, the government can net out payments to itself.

The Congressional Budget Office (CBO) currently estimates the federal government's net interest outlays to be about 1.4 percent of GDP. Although net borrowing has increased by $3 trillion, a significant decline in interest rates has reduced net interest costs from $253 billion in $2008 to $197 billion in 2010.

Interest rates are currently at very low levels. This is partly due to increased savings rates in households and corporations, all of whom are being a bit more careful in dispensing their cash. Also, the U.S. Federal Reserve is deliberately pushing interest rates down below market levels by creating huge quantities of new dollars.

How long can the Fed keep doing this? The more money it creates, the higher will be prices compared to what they would have been. At current levels of money creation, it won't be long before the Fed achieves its stated desire of pushing price inflation up to 2 percent. Then what?

As inflation expectations increase, so will interest rates necessarily increase. Otherwise, lenders would expect to lose value due to inflation. But once this begins to happen, the Fed will have to slow down its money creation in order to avoid overshooting its inflation target.

This means that, unless savings rates continue to rise, the Fed will have trouble keeping interest rates down below market levels. If it continues to inflate the money supply to hold down real interest rates (which are observed interest rates minus the effect of inflation), then it risks increased price inflation and a weaker dollar. But if it slows its money creation, then it reduces the availability of reserves to the banking system. This will also cause interest rates to rise.

Either way, interest rates are headed higher. And as the federal government refinances and increases its debt, its interest payments are also destined to rise.

To add to the joy of the season, Congress is currently attempting to rush through a 1,924-page, $1.2 trillion omnibus spending bill, spruced up with 6,715 Christmas decorations sometimes called “earmarks.”

By the CBO's reckoning, all this will cause government interest payments to rise to 3.4 percent of GDP by 2020. Now we have one more reason to be glad that we are not inclined to join the European Union.